A Law and Finance Approach

José Gabilondo

Focusing primarily on the banking system in the United States, this book offers an innovative framework that integrates a depository bank’s liquidity and its capital adequacy into a unified notion of funding that helps to explain how the 2007–2008 crisis unfolded, why central banks succeeded in resolving the crisis, and how the conceptual legacy of the crisis and its resolution led to lasting changes in bank funding regulation, including new objective requirements for bank liquidity. To provide a comparative context, the book also examines the funding models of non-bank intermediaries like dealer banks and insurers.

Monograph Book

José Gabilondo

This chapter establishes the foundation for the book’s argument by examining three core questions posed by the 2007–2008 financial crisis. First, what exactly does bank funding encompass? Second, markets already impose capital constraints on all firms so why should governments place additional requirements on how banks fund themselves? Moreover, why should funding regulation target banks given that non-bank intermediaries also play an important role in contemporary credit markets? The 2007–2008 financial crisis provided a laboratory for these questions, which post-crisis regulation has tentatively answered with new standards for bank funding liquidity and capital.

José Gabilondo

José Gabilondo

What the bank does as a financial intermediary determines its funding dynamics. These activities include extending credit outright, providing payment services, and promising to provide funds in the future at the election of the borrower. This chapter analyzes how funding these activities leaves the bank’s asset-liability structure vulnerable to financial instability, in particular in its short-term liquidity position. The bank’s treasury function can profitably manage these financial risks because of its unrivaled access to liability funding markets. Also, the federal government stands ready to supplement these private sources with a variety of specialized funds available only to banks.

José Gabilondo

José Gabilondo

This chapter examines the funding of three non-bank intermediaries active in the credit market: dealer banks, insurers and passive investment vehicles. Each of these regulatory silos has a distinctive funding model. Dealer banks active in securities markets as brokers and dealers acquire a large inventory of assets, typically used as collateral for short-term loans that are rolled-over at maturity. This form of funding inventory also creates a financial mismatch in term, although dealer banks tend to otherwise maintain a rough match between their assets and liabilities. The funding practices of insurers and pensions leave them with a converse mismatch: current inflows of premiums and contributions create liquid assets, while the entity’s promises to provide benefits create long-term liabilities. Passive vehicles like asset managers and special-purpose entities pool funds for investment while shifting liquidity risk to their investors or to contractual counterparties.

José Gabilondo

This chapter analyzes how the 2007–2008 crisis and its resolution crystalized the notion of a liquidity value chain in funding markets. In the heyday of the originate-to-distribute model, banks gained access to new funds, investors profited from structured finance products with investment-grade ratings, retail and corporate borrowers benefited from cheap and ample credit, and securitization promoters collected fees. Beginning in 2007, this funding spiral changed direction, leaving even high-quality borrowers without access to refinancing markets. The rescue efforts of central banks and governments helped to conceptualize the crisis in terms of funding practices, business models, contingent liabilities and the money position. This conceptual legacy would influence post-crisis reforms of financial regulation.

José Gabilondo

José Gabilondo

Regulatory capital imposes a complex set of global standards on how banks manage their borrowing and equity issuance. To analyze these standards, this chapter develops the notion of a pro forma regulatory balance sheet derived from the bank’s financial statement of position but adjusted in accordance with prudential policies set by national regulators. The chapter also analyzes post-crisis reforms of regulatory capital, which attempt to increase the bank’s tangible net worth, to link minimum capital requirements to the bank’s business model, and, in general, to make determinations of capital adequacy more responsive to changes in the financial instability of an entity or markets as a whole.

José Gabilondo

José Gabilondo

Regulators had long urged banks to maintain contingency funding plans, but binding minimum standards on the bank’s funding liquidity emerged only as a result of the 2007–2008 crisis. Styled as a liquidity coverage ratio, it seeks to ensure that the bank has adequate liquidity to survive a 30-day funding crisis. The ratio does this through procedures to evaluate the liquidity of assets, to estimate the bank’s inflows, and to measure the bank’s total funding needs during the 30-day period. After breaking out each of the ratio’s major parts, the chapter makes some tentative observations about how the ratio may impact banks and their funding markets, including the development of better techniques for pricing and tracking the use of liquidity within an entity.

José Gabilondo

José Gabilondo

The book concludes with five major conclusions about bank funding. First, bank funding should be seen as an organic notion that internalizes the funding liquidity and loss-absorption consequences of the bank’s role as an intermediary. Second, within this notion short-term funding liquidity – its money position – deserves special, focused attention because it is the bank’s financial threshold for survival. Third, funding regulation – be it of banks or nonbank intermediaries – should be seen as a unified field with inter-related elements that address funding liquidity and loss-absorption in complementary and, to a certain extent, substitutable ways. Fourth, since the crisis lawmakers are more likely to look beyond an enterprise’s regulatory shell to determine whether the enterprise presents financial risks that justify funding regulation. Finally, these developments elevate the status of the bank’s treasury operations, a back office function that has become a hive of compliance initiatives and profit-seeking strategies. As banks contend with growing funding requirements, treasury operations will be at the heart of the business model.